Why Inflation Feels Higher Than the Fed's Target Rate

Investors have paid increased attention to reports on inflation and job market conditions ever since the Great Recession began. The Federal Reserve's dual mandate of full employment and price stability is the underlying basis for its decisions on monetary policy. However, most American consumers measure inflation by their trips to the grocery store, where they can observe changes in prices for regularly purchased items.

At the conclusion of each meeting of the Federal Open Market Committee (FOMC), the Fed releases an FOMC Statement to announce its decision concerning whether any monetary policy changes will be made. The FOMC always references the Fed's dual mandate in explaining the rationale for its decisions. Financial news outlets focus significant attention on labor and inflation reports in search of hints about the Fed’s next move, which could spark a stock market rally in the event of an accommodative or dovish decision. A decision to tighten monetary policy could start a selloff.

Consumers See Inflation

The Fed's persistent explanations concerning low inflation seem perplexing to many American consumers. As the price of gasoline soared to $3.53 per gallon in 2011, consumers understood the pain at the pump as a result of inflation. News reports that the Fed was not satisfied with the inflation rate made little sense to most motor vehicle operators.

The March 16, 2016 FOMC Statement might have provoked some outrage from grocery shoppers, with its assertion that the annual inflation rate continued to run below the Committee's 2% longer-run objective. Supermarket customers had a different perspective on inflation. The prices of uncooked beef roasts and steaks surged 2.5% between February and March 2016. Grapefruit prices skyrocketed 5.2% during that month. The anti-Whole Foods Market (NYSE: WFM) crowd saw chocolate chip cookies climb 3.4% and potato chips jump 4.5% during that period. The gas pump had also turned against consumers in March 2016, as the price of regular unleaded gas soared 10.8% from the previous month.

Differing Measurements of Inflation

What consumers experience as inflation differs from rates of inflation measured by federal agencies. Most people are familiar with the Consumer Price Index (CPI) due to news coverage on the monthly CPI reports from the Bureau of Labor Statistics (BLS). However, the most important measure of inflation for the Federal Reserve is the Personal Consumption Expenditures (PCE) Index, released by the Bureau of Economic Analysis (BEA) in its monthly Personal Income and Outlays report. Specifically, the FOMC places particular emphasis on the measurement of core PCE, which excludes consideration of food and energy expenditures because those prices can change dramatically on a frequent basis. Changes in food and energy costs are not reliable indicators of inflation, due to the influence of a variety of temporary factors.

The CPI is used in determining adjustments to social security payments. The CPI is a widely used reference rate for financial contracts. It is also the reference rate for Treasury inflation-protected securities (TIPS). However, the CPI tends to report a higher inflation rate than the PCE. The Federal Reserve Bank of Cleveland reported that prices as measured by the CPI rose 39% between 2000 and 2014, meanwhile those measured by the PCE rose 31%. As a result, the average annual inflation rate during that period was 2.4%, according to the CPI, and only 1.9%, as indicated by the PCE. The core inflation rates were lower, with core CPI increasing at an average annual rate of 2.0% while core CPI increased at the average annual rate of 1.7% during the same period.

Consumer price inflation rates may also vary by locale. For example, the BLS reported that consumer prices in Seattle rose 2.2% during the 12 months preceding February 2016 compared to the nationwide increase of only 1.0% during that period.

Outlook on Future Inflation

Economists at the Dallas Federal Reserve look beyond headline levels of inflation and include their own formula in making inflation assessments: the Dallas Fed’s Trimmed Mean PCE measure of core inflation. This metric trims away items with the most extreme upward and downward monthly price movements.

While the headline measure of inflation has been running well below the Fed’s 2% objective, the 12-month change in the Dallas Fed's trimmed mean ranged consistently between 1.6 and 1.7% from early 2014 until the end of 2015. This measure has risen to between 1.8 and 1.9% in 2016. These readings led Dallas Fed president Robert S. Kaplan to express confidence, on April 29, 2016, that headline inflation would ultimately increase toward the Fed's 2% target over the medium term. When that happens, both the Fed and the average American consumer will be in agreement on the degree of inflation that is taking place. However, the two groups might disagree on the extent of the increase.